1. INTRODUCTION AND METHODOLOGY 1.1Introduction The poor, like the rest of society, need financial...

7/24/2019 1. INTRODUCTION AND METHODOLOGY 1.1 Introduction The poor, like the rest of society, need financial products

1/112

Determinants of GLP and Profitability of selected MFIs| 1

1. INTRODUCTION AND METHODOLOGY

1.1 Introduction

The poor, like the rest of society, need financial products and services to

build assets, stabilize consumption and protect themselves against risks.

Microfinance serves as the last-mile bridge to the low-income population

excluded from the traditional financial services system and seeks to fill this gap

and alleviate poverty. Microfinance loans serve the low-income population in

multiple ways by:

Providing working capital to build businesses

Infusing credit to smooth cash flows and mitigate irregularity in

accessing food, clothing, shelter, or education and

Cushioning the economic impact of shocks such as illness, theft,

or natural disasters. Moreover, by providing an alternative to the

loans offered by the local moneylender priced at 60% to 100%

annual interest, microfinance prevents the borrower from

remaining trapped in a debt trap which exacerbates poverty.

Microfinance loans in India range in size from $100 to $500 per loan with

interest rates typically between 25% and 35% annually. The microfinance

model is designed specifically to help the low income population overcome

typical challenges such as illiteracy, lack of financial knowledge and deficiency

of collateralizable assets. At the same time, the model takes advantage of

existing community support systems and networks to encourage financial

discipline and ensure high repayment rates

It is critical to evaluate the progress of the Indian microfinance sector

within the context of global microfinance. With one of the highest growth rates

Jagadeesh T - Department of Commerce - SKASC


2/112


globally since 2002, the Indian microfinance sector has emerged as one of the

most socially conscious, commercially viable, and financially sustainable.

According to a MIX market study, India has one of the lowest average loan sizes

of around $150 as well as the lowest yield on portfolio of 21.2%. The small

loan size combined with the low interest rates testify to the social inclination of

Indian Micro Finance Institutions, which seek to genuinely foster financial

inclusion among the poor and alleviate poverty. In conjunction with this goal,

Indian Micro Finance Institutions have succeeded not only in comfortably

covering costs, but also returning healthy profits and Return on Assets (ROA).

This highlights Indian Micro Finance Institutions operational efficiency and

ability to function on tight budgets. True, Micro Finance Institutions in other

countries such as Brazil and Mexico have higher profit margins, but they offer

significantly larger loans with interest rates typically between 40-65%.

The inherent efficiency and resiliency of the Indian microfinance industry

proved critical during the recent financial meltdown during which growth

continued unabated despite a slowdown in the flow of funds which negativelyaffected growth in microfinance in other markets around the world. This

demonstrated self-sustainability is prognostic of the long- term viability and

potential of the sector. Moreover, the Indian financial system as a whole has

demonstrated its long-term confidence in the industry through its own

investment choices. Whereas the global average of domestic investment in

microfinance hovers around 65%, over 90% of the funding in India comes

through domestic channels, highlighting confidence in the underlying business

model and expectations of high future growth and returns.

1.2 Statement of the Problem



3/112


Study on financial performance of Micro Finance Institutions is neglected

topic but requires a considerable amount of attention for policy purposes.

With the above constrains and challenges in mind, the present study focuses

on financial efficiency. Since, there are numerous literature available on impact

of microfinance on women empowerment and poverty eradication, the

researcher has considered a different study on assessment of Micro Finance

Institutions in India.

In India, micro finance is provided by a variety of institutions. These

include banks (including commercial banks, RRBs and co-operative banks),

primary agricultural credit societies and MFIs that include NBFCs, Section-25

companies, trusts and societies. But only the banks and NBFCs fall under the

regulatory purview of the Reserve Bank of India. Other entities, e.g., MFIs are

covered in varying degrees of regulation under their respective State

legislations. There is no single regulator for this sector. As a result, MFIs are

not required to follow some standard rules and are not subject to minimum

capital requirements and prudential norms. This has weakened their

management and governance, as they do not feel it mandatory to adopt some

specific systems, procedures and standards. Since MFIs are unregulated, one

cannot know about their internal financial health.

There is no specific code of conduct for the MFIs. It is not uncommon to

see many not for profit MFIs transformed to fully commercial and for profit

organizations. Also, many NGOs pursuing microfinance are in a stage of

transforming themselves into full-fledged MFIs. Many MFIs, basically promoted

for taking care of the needs of the poor, are setting their development goals and

business interests. In recent past, some erring MFIs in Andhra Pradesh have



4/112


been charged with exploiting the poor with usurious interest rates and

intimidating the borrowers by forced loan recovery practices.

1.3 Significance of the Study

Affordability of loan is equally important to the access of financial

services to the poor. Economic fundamentals exhort that every borrower is

interest sensitive and the capacity of borrowing decreases with increase in

interest rates. High interest rates may prove to be counterproductive, and

weaken the social and economic condition of poor clients. The high interest rate

charged by the MFIs from their poor clients is perceived as exploitative. Theinterest rates are not well regulated for private MFIs as well as for formal

banking sector. However, there are certain self-regulated interest rates fixed by

intermediate and apex institutions. MFIs adopt different approaches for fixing

the interest rates or service charges on loans to members.

A complete picture of the MFI sector regarding the terms and conditions

of providing loans and financial services to their clients are not available.

Although the interest rates of some MFIs are regulated but they impose some

charges like transaction costs, the cost of documents and some other charges.

This increases the cost of borrowing, and thus making it less attractive.

Normally, banking sector is charging 9 to 10 per cent interest rate per annum

from the SHG members, while MFIs charge comparatively higher interest rate

which is generally 11 to 24 per cent per annum. But this interest rate varies

significantly according to the lending conditions and policy of the MFI.

Another problem faced by the microfinance program is the depth of

services provided. Though the outreach of the program is expanding, large

number of people are provided with microfinance services but the amount of



5/112


loans is very small. The average loans per member in both MFIs and SHGs are

between Rs. 3,500 and 5,000. The average value of loans per SHG member for

various years.

This amount is not sufficient to fulfil the financial needs of the poor

people. The duration of the loans is also short. The small loan size and short

duration do not enable most borrowers to invest it for productive purposes.

They, generally, utilize these small loans to ease their liquidity problems.

These factors are the critical points in evaluating the performance of the

Micro Finance Institutions. The researcher has made a maiden attempt to

analyze the performance on the basis of Gross Loan Portfolio to Total Assets

and Profit Margin.



6/112


1.4 Objectives

With the above theoretical background, the present study aims:

To study the relationship between Gross Loan Portfolio to Total Assets

(GLPTA) and Capital to Asset Ratio (CAR), Debt Equity Ratio (DER),

Operating Expense (OE), Personnel Expense (PE), Administrative

Expense (AE), Personnel Allocation Ratio (PAR), Total Expense (TE) and

Financial Expense (FE),

To study the relationship between Profit Margin (PM) and Return on Asset

(ROA), Return on Equity (ROE) and Financial Revenue (FR).

1.5 Research Methodology

1.5.1 Sources of Data

The study is primarily based on secondary data. The required data have

been collected from mix market and financial reports from the respective Micro

Finance Institutions.

1.5.2 Sampling Framework

Financial reports of selected 5 Micro Finance Institutions have been

taken based on total net fixed assets, whose turnover lies between 4.5 to 25

crores has been considered for analysis.

1.5.3 Statistical Instrument

To study the influence of independent variables on dependent variables,

multiple regression analysis is employed.



7/112


1.6 Variable Definition

1.6.1 Efficiency

Dependent Variable Independent Variable

GLPTAGross Loan Portfolio to

Total Asset

CAR-Capital to Asset Ratio

DER-Debt Equity Ratio

OE-Operating Expense

PE-Personnel Expense

AE-Administrative Expense

PAR-Personnel Allocation Ratio

TE-Total Expense

FE-Financial Expense

1.6.1.1 Gross Loan Portfolio to Total Asset (GLPTA)

The outstanding principal balance of all of an MFIs outstanding

loans, including current, delinquent, and restructured loans, but not loans

that have been written off. It does not include interest receivable. Althoughsome regulated MFIs may be required to include the balance of interest accrued

and receivable, the MFI should provide a note that gives a breakdown between

the sum of all principal payments outstanding and the sum of all interest

accrued. Some MFIs choose to break down the components of the gross loan



8/112


portfolio. The gross loan portfolio is frequently referred to as the loan portfolio

or loans outstanding, both of which create confusion as to whether they refer to

a gross or a net figure. The gross loan portfolio should not be confused with the

value of loans disbursed.

Gross Loan Portfolio to Total Asset =

1.6.1.2 Capital to Asset Ratio (CAR)

This is the ratio of capital to total assets, without the latter being risk

weighted. Capital is measured as total capital and reserves as reported in the

sectorial balance sheet; for cross-border consolidated data, Tier 1 capital can

also be used. It indicates the extent to which assets are funded by other than

own funds and is a measure of capital adequacy of the deposit-taking sector. It

complements the capital adequacy ratios compiled based on the methodology

agreed to by the BCBS. Also, it measures financial leverage and is sometimes

called the leverage ratio.

Capital to Asset Ratio =

1.6.1.3 Debt Equity Ratio (DER)

This is calculated by using debt as the numerator and capital and

reserves as the denominator. It is a measure of corporate leverage the extent to

which activities are financed out of own funds.


Gross Loan Portfolio

Adjusted Total Equity

Adjusted Total Liability


9/112


Debt Equity Ratio =

1.6.1.4 Operating Expense (OE)

Includes personnel expense and administrative expense, but excludes

financial expense and loan loss provision expense. It does not include expense

linked to non-financial services. The authors recognize that it is common to

refer to the sum of all expenses from operations (i.e., financial and loan-loss

provision expenses) in the definition of this term, just as operating revenue

includes all revenue from operations. However, the definition proposed here

corresponds with the most common usage in banking.

Operating Expense =

1.6.1.5 Personnel Expense (PE)

Includes staff salaries, bonuses, and benefits, as well as employment

taxes incurred by an MFI. It is also referred to as salaries and benefits or staff

expense. It may also include the costs of recruitment and/or initial orientation.

It does not include ongoing or specialized training for existing employees, which

is an administrative expense.

Personnel Expense =

1.6.1.6 Administrative Expense (AE)


Adjusted Operating Expense

Adjusted Personnel Expense


10/112


Non-financial expenses directly related to the provision of financial

services or other services that form an integral part of an MFIs financial

services relationship with its clients. Examples include depreciation, rent,

utilities, supplies, advertising, transportation, communications, and consulting

fees. It does not include taxes on employees, revenues, or profits, but may

include taxes on transactions and purchases, such as value-added taxes.

Administrative Expense =

1.6.1.7 Personnel Allocation Ratio (PAR)

Payments from the MFI to its staff for services rendered; usually the

largest operating expense for an MFI

Personnel Allocation Ratio =

1.6.1.8 Total Expense (TE)

Includes personnel expense and administrative expense, but excludes

financial expense and loan loss provision expense. It does not include expense

linked to non-financial services. The authors recognize that it is common to

refer to the sum of all expenses from operations (i.e., financial and loan-loss

provision expenses) in the definition of this term, just as operating revenue

includes all revenue from operations. However, the definition proposed here

corresponds with the most common usage in banking.

Total Expense =


Number of Loan Officers

Number of Loan Officers

Number of Personnel

Adjusted (financial expense + Net Loss +Provision Expense

+ Operating Expense)


11/112


1.6.1.9 Financial Expense (FE)

All interest, fees, and commissions incurred on all liabilities, including

deposit accounts of clients held by an MFI, commercial and concessional

borrowings, mortgages, and other liabilities. It may also include facility fees for

credit lines. It includes accrued interest as well as cash payment of interest.

Financial Expense =

1.6.2 Profitability

Dependent Variable Independent Variable

PM Profit Margin ROA Return on Asset

ROE -Return on Equity

FR Financial Revenue


Adjusted Financial Expense

Adusted Averae Total Assets


12/112


1.6.2.1 Profit Margin (PM)

Measures a providers profitability in terms of its effectiveness in

managing costs.

Profit Margin =

1.6.2.2 Return on Asset (ROA)

This is calculated by dividing net income before extraordinary items and

taxes (as recommended in the FSI Guide) by the average value of total assets

(financial and nonfinancial) over the same period. This is an indicator of bank

profitability and is intended to measure deposit takers efficiency in using their

assets.

Return on Asset =

1.6.2.4 Return on Equity (ROE)

This is calculated by using earnings before interest and tax as the

numerator and the average value of capital and reserves over the same period

as the denominator. It is a profitability ratio, which is commonly used to

capture nonfinancial corporations efficiency in using their capital.

Return on Equity =

1.6.2.5 Financial Revenue (FR)

There are two types of financial revenue they are financial revenue from

investments and Loan portfolio. Revenue from interest, dividends, or other


Net Income before Taxes and Donations

-

Net Operating Income - Taxes

Net Operating Income - Taxes


13/112


payments generated by financial assets other than the gross loan portfolio,

such as interest-bearing deposits, certificates of deposit, and treasury

obligations. This includes not only interest paid in cash, but also interest

accrued but not yet paid.

Revenue from interest earned, fees, and commissions (including late fees and

penalties) on the gross loan portfolio only. This item includes not only interest

paid in cash, but also interest accrued but not yet paid.

Financial Revenue =

1.7 Tool / Model

GLPTA = +1CAR + 2DER + 3OE+ 4PE + 5AE + 6PAR

+ 7TE + 8FE + 9OELP +

Where,

GLPTA = Gross Loan Portfolio to Total Asset

= Constant

19= Estimated coefficients

= error term

PM = +1AOB + 2ROA + 3ROE+ 4FR + 5YGPP +

Where,

PM= Profit Margin

= Constant

15 = Estimated coefficients

= error term


Adjusted Financial revenue


14/112


1.8 Limitations of the Study

The present study is purely based on secondary data all the drawbacks

applicable to secondary data are also applicable to those of this study.

The study has taken into consideration of 5 sample Microfinance

Institutions which may not represent the entire population.

The study is quantitative in nature. The study has ignored the qualitative

aspects of Micro Finance Institutions.

2. REVIEW OF LITERATURE

Padma Manoharan (2011)1In the study analyzed the financial

performance of various microfinance institutions operating in India based on

their profile, financial health and performance. According to them, MFIs must

be able to sustain themselves financially in order to continue pursuing their

lofty objectives, through good performance and vivid functioning. Thus, there is

an urgent need to widen the scope, outreach as also the scale of financial

services to cover the unreached population.

Oliver Bright (2011)2In the study analyzed the banks and financial

institutions in an annual credit plan with the current year target and previous

year target achieved in terms of value and achieved percentage on target fixed.

In this study, they assessed the financial performance of MFIs in India with the

objective of finding out the pattern of growth of micro credit in target fixed,

target achieved in terms of value and in terms of percentage achieved on target

fixed. They focused mostly to find the growth pattern of micro credit fixed and

offered to Kanyakumari District through the annual credit plan during 2005 to

2009.As per their analysis, it was concluded that the growth pattern of the



15/112


micro credit offered in Kanyakumari District is found to be negative in most of

the schemes and plans of micro credit.

Abdul Qayyum (2009)3In the study analyzed the efficiency and

sustainability of MFIs in South Asia with the objective of estimating the

efficiency and sustainability of microfinance institution working in the South

Asian countries such as Bangladesh, Pakistan and India. For the efficiency

analysis, they used non parameter ric Data Envelopment Analysis. The

technical efficiency figures for Pakistan, Bangladesh and India are 0.395,

0.087, and 0.28, respectively, while average pure technical efficiencies for these

countries respectively range between0.713-0.823, 0.175-0.547 and 0.413-

0.452. Three countries combine analysis revealed that there are two efficient

MFIs under CRS and five efficient MFIs under VRS assumption in these

countries.

Alain de Crombrugghe(2007)4in the study analyzed using regression

analysis to study the determinants of self-sustainability of a sample of

microfinance institutions in India. They investigated particularly three aspects

of sustainability: cost coverage by revenue, repayment of loans and cost-

control. Their results suggested that the challenge of covering costs on small

and partly unsecured loans can indeed be met, without necessarily increasing

the size of the loans or raising the monitoring cost. Regression results showed

that increasing the size of the loans works only up to a point to reduce cost,

because large loans require more individual monitoring than small ones which

fit into group mechanisms.

Alok Misra(2006)5In the study analyzed assessed the microfinance

sector in India cannot be seen in isolation of the overall economy the economy



16/112


comprising nearly 110 million agricultural holdings, over 60 percent of those

with an area below 1 hectare, and nearly 35 million non-agricultural

enterprises. The stark reduction of bank credit proportion to small borrowers

from 18 percent in 1994 to 5.3 percent in 2002 shows that the challenge of

extending financial services, at least to all the productive citizens of the

country, must be tackled afresh.

Anne-Lucie Lafourcade (2005)6In the study analyzed found out that out

of the 163 MFIs that provided information for this study, 57 percent were

created in the past eight years and 45 percent of those in the past four.2African MFIs appear to serve the broad financial needs of their clients. They

asserted that MFIs in Africa tend to report lower levels of profitability, as

measured by return on assets, than MFIs in other global regions. Among the

African MFIs that provided information from their study, 47 percent post

positive unadjusted returns; regulated MFIs report the highest return on assets

of all MFI types, averaging around 2.6 percent. MFIs in Africa also

demonstrated higher levels of portfolio quality, with an average portfolio at risk

over 30 days of only 4.0 percent.

Abhijit Banerjee (2013)7in the study analyzed reports on the first

randomized evaluation of the impact of introducing the standard microcredit

group-based lending product in a new market. In 2005, half of 104 slums in

Hyderabad, India were randomly selected for opening of a branch of a

particular microfinance institution (Span- Dana) while the remainder were not,

although other MFIs were free to enter those slums. Fifteen to 18 months after

Spandana began lending in treated areas, households were 8.8 percentage

points more likely to have a microcredit loan. This studythe first and longest

running evaluation of the standard group-lending loan product that has made



17/112


microfinance known worldwideyields a number of results that may prompt a

rethinking of the role of microfinance. The first result is that, in contrast to the

claims sometimes made by MFIs and others, demand for microloans is far from

universal. By the end of our three-year study period, only 38% of households

borrow from an MFI30, and this is among households selected based on their

relatively high propensity to take up microcredit. However, these results are not

specific to this context: similar findings emerge from four other studies run on

different continents, in booms and busts, and in both urban and rural

contexts.

Befekadu B. Kereta (2007)8in the study analyzed Ethiopia is one of the

least developed countries. The per capita income of the country, though it

showed improvement in recent years, is only USD 180 as at end of 2005/061.

Most of the poor, which mainly argued to be constrained by absences of credit

access, participant in some kind of informal sector ranging from small petty

trading to medium scale enterprises. Several micro finance institutions (MFIs)

have established and have been operating towards resolving the credit access

problem of the poor. In light of this, this paper attempted to look at MFIs

performance in the country from outreach and financial sustainability angles

using data obtained from primary and secondary sources. The study finds

that the industry's outreach rise in the period from 2003 to 2007 on average by

22. 9 percent. It identified that while MFIs reach the very poor, their reach to

the disadvantages particularly to women is limited (38.4 Percent). From

financial sustainability angle, it finds that MFIs are operational sustainable

measured by return on asset and return on equity and the industry's profit

performance is improving over time. The paper examines the performance of

MFIs in relation to outreach and financial sustainability. It reviews literatures



18/112


on core performance indicators of MFIs. The literatures noted that MFIs could

be examined through three main polar: outreach to the poor, financial

sustainability and welfare impact. The welfare impact assessment is not

covered in this paper due to time and money limitations. Both secondary and

primary data (obtained from questionnaire distributed to representative sample

MFIs) has been employed in the study. In the analysis process, the study has

adopted simple correlation and descriptive analysis techniques. While,

dependency ratio measured by the ratio of donated equity to total capital

decline, ratio of retained earnings to total capital is raising letting the industry

to be financial self-sufficient. Using Non performing Loan (NPLs) to loan

outstanding ratio indicator the study found out that MFI financial

sustainability is in a comfort zone with average NPLs ratio of 3.2 percent for the

period from 2005 to 2007. The study also found low but increasing default rate.

Marie Godquin (2006)9in the study analyzed analysis of the

performance of microfinance institutions (MFIs) in terms of repayment. We use

1629 loan observations to analyze with a profit the determinants of the

repayment performance of borrowers of the BRAC, the BRDB and the Grameen

Bank. We test for endogeneity of the size and duration of the loan in the

determination of repayment and use instrumental variables to correct for it. In

a second step, we produce an ex-post analysis of the loan allocation of the

three MFI. The age of the group, a proxy for social ties inside the group, showed

a significant negative impact on the reimbursement which raises the question

of the necessity of specific incentives instruments for experienced borrowers.

The social ties of the borrower out of his group have the expected positive

impact as well as the proxy for dynamic incentives. In terms of sex, group

homogeneity proved a positive impact on repayment performance but we



19/112


cannot attribute the same positive impact to group homogeneity in terms of age

or education level. Non-financial services did not show a positive impact in all

the cases whereas MFIs tend to attribute bigger loans to borrowers who have

access to these services.

Manfred Zeller(2001)10In the study analyzed a systematic sampling has

been adopted through the contacting of international NGOs and networks

supporting various MFIs. The information has been complemented by a review

of publications and technical manuals on microfinance. The database of MFIs

from 85 developing countries shows 1,500 institutions (790 institutionsworldwide plus 688 in Indonesia) supported by international organizations.

They reach 54 million members, 44 million savers (voluntary and compulsory

savings), and 23 million borrowers. The total volume of outstanding credit is

$18 billion. The total savings volume is $12 billion, or 72 percent of the volume

of the outstanding loans. MFIs have developed at least 46,000 branches and

employ around 175,000 staff. On the whole, MFIs reach 54 million members,

who have received $18 billion in loans and accumulated $13 billion in savings.

With these figures, the Micro-Credit Summit objective to reach 100 million poor

people by 2005 appears be achievable if one were to assume that most of the

current MFI clients were poor. However, MFIs are highly concentrated in size

(3 percent of the largest MFIs reach 80 percent of the members). If the

stakeholders of the Micro-Credit Summit wish to achieve their goal, further

client growth among the bigger MFIs should be necessary. This is because the

many small MFIs will not contribute much to the total numbers even if they

would double or triple their client numbers by 2005. However, it will be

necessary to support the change of scale of small but efficient MFIs.



20/112


Marc J. Epstein (2005)11In the study analyzed attempt to carefully

specify the antecedents and consequences of investments in microfinance, to

examine the nature and amount of existing contribution, and consider how to

enhance the contribution of microfinance to the alleviation of global poverty.

We have completed a thorough review of the literature, examination of prior

impact studies and data, interviews with senior officers at Opportunity

International, and analysis of data and field interviews of microfinance

activities in Ghana. Those impacts can certainly include a) providing the poor

with increased access to working capital and other financial services and b)

reducing risks and vulnerability and helping to protect the poor from lifesfinancial shocks and helping to stabilize their income. And, the shocks can be

significant and can quickly eliminate (at least in the short term) many of the

benefits created by personal financial improvements. But, microfinance can do

more. It can enable its borrowers to cross the poverty line and stay across it.

It may be able to facilitate significant improvements in social condition in

additional to economic improvements.

Christian Ahlin (2009)12In the study analyzed the little is known about

whether and how the success of microfinance institutions (MFIs) depends on

the country-level context, in particular macroeconomic and macro-institutional

features. Understanding these linkages can make MFI evaluation more

accurate and, further, can help to locate microfinance in the broader picture of

economic development. We collect data on 373 MFIs and merge it with country-

level economic and institutional data. Evidence arises for complementarity

between MFI performance and the broader economy. This study is an attempt

to place microfinance institutions in national context. We examine country-level

determinants of success of 373 MFIs from around the world. There is evidence



21/112


for complementarity between overall economic performance and MFI

performance. Growth appears good for MFI financial performance, in part due

to its effect on default. Breaking even appears easier to do in richer countries

at least up to a point. Also, a deeper financial sector is associated with lower

operating costs, lower default, and lower interest rates, suggesting that broad

financial competition does benefit micro-borrowers.

CS Reddy (2005)13In the study analyzed in the early 1980s, the GoI

launched the Integrated Rural Development Program (IRDP), a large poverty

alleviation credit program, which provided government subsidized creditthrough banks to the poor. It was aimed that the poor would be able to use the

inexpensive credit to finance themselves over the poverty line. Recently,

microfinance has garnered significant worldwide attention as being a

successful tool in poverty reduction. In 2005, the GoI introduced significant

measures in the annual budget affecting MFIs. Specifically, it mentioned that

MFIs would be eligible for external commercial borrowings which would allow

MFIs and private banks to do business thereby increasing the capacity of MFIs.

In some areas, there is a reasonable amount of infrastructure that state-owned

rural banks operate. As some SHGs have grown and matured to a sizeable

scale, they need access to more financial services. Governments can address

this need through their state-owned banks by introducing flexible and easily

accessible products. Specifically, products such as innovative savings

products, micro-insurance, larger loans and enterprise financing can be

introduced.

Giovanni FERRO LUZZI (2006)14In the study analyzed Measuring the

performance of microfinance institutions (MFIs) is not a trivial task. Indeed,



22/112


looking at the financial sustainability of an MFI only gives one feature of its

performance. As many MFIs primarily exist in order to help the poorest people,

one also has to include aspects of outreach in their performance. Hence, MFIs

performance can be termed multidimensional. This paper illustrates how some

statistical tools can offer new insights in the context of MFIs performance

evaluation. Factor analysis is used in a first step to construct performance

indices based on several possible associations of variables without posing too

many a priori restrictions. Microcredit is often promoted as an efficient tool to

help the poor, since it is based on sound economic principles. Rates of return

of small scale investments can be very high and explain why some people are

ready to pay high interest rates in order to finance them. However, market

failures and relatively high transaction costs can prevent a substantial part of

these investments to be realized through private financial intermediaries,

especially in remote rural areas. MFIs ambition is to fill the gap. As discussed

earlier, they can do so either by focusing on the poor and expanding their

outreach, or they may prioritize their financial viability.

Valentina Hartarska (2004)15In the study analyzed paper presents the

first evidence on the impact of external governance mechanisms, board

diversity and independence, and management compensation on outreach and

sustainability of microfinance institutions in Central and Eastern Europe and

the Newly Independent States. Results indicate that among external

governance mechanisms only auditing affects outreach, whereas regulation

and rating do not affect performance. Board diversity improves both outreach

and sustainability while larger and less independent boards lower

sustainability. Performance-based compensation is not effective in aligning the

interest of managers and stakeholders, and underpaying managers reduces



23/112


outreach. External governance mechanisms, specifically supervision by

regulatory authority and rating by independent agency, are not effective

mechanisms of control. Only auditing has a positive effect on outreach.

Internal governance mechanisms, particularly the board matter, as MFIs with

local boards achieve better sustainability. Consistent with other studies on

board size and independence, this paper finds that in microfinance larger

boards and boards with higher proportion of insiders have worse financial

results. This study finds that traditional mechanisms designed to align the

interests of managers with those of other stakeholders have a limited role in

microfinance. Performancebased compensation of managers does not improve

MFI performance. However, offering lower salary so that only managers

committed to the mission would take the job (as suggested by the NGO

literature) is ineffective because MFIs with underpaid managers achieve less

outreach. Finally, manager experience does not affect sustainability and its

impact on depth of outreach is small in magnitude.

Nathalie Holvoet (2005)16Evaluations of the effects of microfinance

programs on womens empowerment generate mixed results. While some are

supportive of microfinances ability to induce a process of economic, social and

political empowerment, others are more skeptical and even point to a

deterioration of womens overall well-being. Against this background,

development scholars and practitioners have sought to distil some of the

ingredients that might increase the likelihood of empowerment or at least

reduce adverse effects. This article formally tests the impact of some of the

suggested changes in program features on one particular dimension of

empowerment: decision-making agency. Womens group membership seriously

shifts overall decision-making patterns from norm-guided behavior and male



24/112


decision-making to more joint and female decision-making. Longer-term group

membership and more intensive training and group meetings strengthen these

patterns. In terms of which particular features in group-based lending are most

important, loaners themselves suggest that peer pressure and the availability of

a group fund, which they see as a lender of last resort for consumptive and

emergency purposes, increased the probability that the loans were effectively

used for the intended productive purpose. They also felt that their position in

the household had improved as they had secured access to long-term financial

resources through their personal savings account and the group fund. Social

group intermediation had further gradually transformed groups into actors of

local institutional change. As such they were increasingly involved in extra-

household bargaining with the community, thereby strengthening their

individual fallback position within the household.

Jonathan Morduch (2003)17Poor households face many constraints in

trying to save, invest, and protect their livelihoods. They take financial

intermediation seriously and devote considerable effort to finding workable

solutions. Most of the solutions are found in the informal sector, which, so far,

offers low-income households convenience and flexibility unmatched by formal

intermediaries. The microfinance movement is striving to match the

convenience and flexibility of the informal sector, while adding reliability and

the promise of continuity, and in some countries it is already doing this on a

significant scale. Getting to this point reaching poor people on a massive scale

with popular products on a continuous basis has involved rethinking basic

assumptions along the way. The microfinance movement is thus striving to

match the convenience and flexibility of the informal sector, while adding

reliability and the promise of continuity, and in some countries it is already



25/112


doing this on a significant scale. Getting to this point reaching poor people

on a massive scale with popular products on a continuous basis has involved

rethinking basic assumptions along the way, and programs in Bangladesh and

Indonesia are still developing new products and approaches.

John Weiss (2004)18The microfinance revolution has changed attitudes

towards helping the poor in both Asia and Latin America and in some countries

has provided substantial flows of credit, often to very low-income groups or

households, who would normally be excluded by conventional financial

institutions. Much has been written on the range of institutional arrangementspursued in different organizations and countries and in turn a vast number

studies have attempted to assess the outreach and poverty impact of such

schemes. However, amongst the academic development community there is a

recognition that perhaps we know much less about the impact of these

programs than might be expected given the enthusiasm for these activities in

donor and policy-making circles. To quote a recent authoritative volume on

microfinance. Despite the current enthusiasm among the donor community for

microfinance programs, rigorous research on the outreach, impact and cost-

effectiveness of such programs is rare. Design of aid programs would ideally

incorporate evidence on all three points, but the research that does exist

generally focuses on only one of these criteria: either outreach, impact or cost-

effectiveness. In part this reflects the difficulty of establishing an appropriate

statistical methodology and implementing those standards in practice, and in

part no doubt reflects the variation found in practice in the way in which

microfinance operates. The evidence surveyed here suggests that the

conclusion from the early literature, that whilst microfinance clearly may have



26/112


had positive impacts on poverty it is unlikely to be a simple panacea for

reaching the core poor, remains broadly valid.

Rajesh Chakrabarti (2006)19Microfinance is gathering momentum to

become a major force in India. The self-help group (SHG) model with bank

lending to groups of (often) poor women without collateral has become an

accepted part of rural finance. The paper discusses the state of SHG-based

microfinance in India. With traditionally loss-making rural banks shifting their

portfolio away from the rural poor in the post-reform period, SHG-based

microfinance, nurtured and aided by NGOs, have become an importantalternative to traditional lending in terms of reaching the poor without

incurring a fortune in operating and monitoring costs. The government and

NABARD have recognized this and have emphasized the SHG approach and

working along with NGOs in its initiatives. Over half a million SHGs have been

linked to banks over the years but a handful of states, mostly in South India,

account for over three-fourth of this figure with Andhra Pradesh being an

undisputed leader. In this paper we have sought to provide a birds-eye view of

the microfinance sector in India. There have definitely been significant

advances in recent years and the concept and practice of SHG-based

microfinance has now developed deep roots in many parts of the country.

Impact assessment being rather limited so far, it is hard to measure and

quantify the effect that this Indian microcredit experience so far has had on

the poverty situation in India. Doubtlessly, a lot needs to be accomplished in

terms of outreach to make a serious dent on poverty. However, the logic and

rationale of SHG-based microfinance have been established firmly enough that

microcredit has effectively graduated from an experiment to a widely accepted

paradigm of rural and developmental financing in India.



27/112




28/112


Richard L. Meyer (2002)20Major investments have been made in

developing microfinance in Asia with reducing poverty as one of the frequently

stated objectives. A variety of institutional forms of microfinance are being

introduced in the region including by the ADB and financial institutions

pursue different objectives, so it is difficult to assess how well microfinance is

actually contributing to poverty alleviation. There is little systematic data

available on which to make global or regional generalizations. The objective of

this paper is to provide some insights into how well the industry is performing

by summarizing and evaluating key studies and data for the region. A critical

triangle of microfinances, including outreach, sustainability and impact, isused as the conceptual framework to organize the presentation. Criteria are

defined for these three objectives and methodological problems are discussed

for each. Evaluating impact presents the most serious empirical challenge.

There is a tendency to adopt the model of many Bangladesh MFIs in expecting

clients to follow a lockstep system of borrowing ever-larger loans and

continuously attending weekly meetings to pay installments and deposit

savings. The one size fits all approach to lending is too inflexible to meet

adequately the demands of heterogeneous clients, and results in multiple

memberships (overlap), switching MFIs, dropouts, loan delinquencies and

continual reliance on informal sources of financial services.



29/112

Rich

(0.6

mmHH)Middle Class

(11mm HH)

Aspirers

(41mm HH)

Depried

(135mm HH)


3. MICRO FINANCE INSTITUTIONS - AN OVERVIEW

3.1 Target of Microfinance

The fundamental reason behind the Indian microfinance industrys

impressive growth is that it is fulfilling a critical need of its target audience, the

low-income population, which has thus far remained unaddressed by the

traditional financial services

sector. Currently, a total

population of 1.1 billion is being

served by 50,000 commercial

banks, 12,000 co-operative bank

offices, 15,000 regional rural

banks and 100,000 primary

agriculture societies. This

density of financial services,

however, belies the availability of

financial services to low-income households, which make up a significant

chunk of the Indian population. Before exploring why financial services have

failed to reach this segment of the population, it is necessary to first define

their target.

The Indian population can be divided into four categories based on

household income levels. The Rich who make up 0.4% of the households have

an annual household income greater than $20,000. The Middle Class

comprises 11 million households, or 5.9% of the total households, and has an



30/112


annual household income between $4,000 and $20,000. The Aspirers make up

nearly22% of the households and have an annual household income between

$1,800 and $4,000. Lastly, the deprived segment, the prime target of the

microfinance industry, comprises 135 million or 72% of the households and

has an annual household income below $1,800.Despite the density and

robustness of the formal Indian financial system, it has failed to reach the

deprived segment, leaving approximately 135 million households entirely

unbanked. The size of India's unbanked population is one of the highest in the

world, second only to that of China. The microfinance sector targets the poorer

portion of the Aspirer segment and the mid to richer portion of the deprived

segment. The industry has thus far been able to create a service model and

products that are suitable to these segments and these services and products

have proven successful in affecting improvements in the clients economic

status. The reasons behind the formal financial sectors failure to reach such a

large segment of the Indian population are manifold and operate in a self-

reinforcing manner. The principal prohibiting factor is that banks face

extremely high fixed and variable costs in servicing low income households,

resulting in high delivery costs for relatively small transactions. Much of the

low income population is located in rural areas that are geographically remote

and inaccessible. For this population, the cost of visiting a traditional bank

branch is prohibitive due to the loss of wages that would be incurred in the

time required.

Concurrently, from a banks perspective, the cost of operating a branch

in a remote location is financially unfeasible due to the low volume and high

cost dynamic. Moreover, low income households are not interested in the same

products that are usually utilized by the rest of the population because they



31/112


have different immediate needs, lower financial capacities and variable income

streams.

The unsuitability of existing credit products for low income households is

exacerbated by a general unavailability of collateralizable assets. Additionally,

the low income population is often illiterate and lacks financial knowledge,

making it nearly impossible for it to even contemplate availing existing financial

services, which provide no ancillary support to mitigate these challenges.

In the absence of access to formal financial services, the low income

segment has traditionally relied on local moneylenders to fulfill their financial

needs. While this money is readily available, it is often exorbitantly priced at

60%-100% annual yields and forces the borrower into a classic debt trap,

entrenching her in poverty. Credit from moneylenders has not traditionally

acted as a tool for business expansion or enhancement of quality of life, but

rather as a lifeline for immediate consumption or healthcare needs.

3.2 Microfinance Business Model

The microfinance business model is designed to address the challenges

faced by the traditional financial services sector in fulfilling the credit

requirement of the low income segment at an affordable and sustainable cost.

Most Micro Finance Institutions follow the Joint Liability Group (JLG) model. A

JLG consists of five to ten women who act as co-guarantors for the other

members of their group. This strategy provides an impetus for prudent self-

selection of reliable and fiscally responsible co-members. Moreover, the JLG

has an inbuilt mechanism that encourages repayment in a timely fashion as

issuance of future loans is contingent upon the prior repayment record of the

group.



32/112


Micro-loan sizes vary from an initial loan size between $100 and $150 to

subsequent loans of $300 to $500 with an annual interest rate between 25%

and 35%. The term loans are structured with weekly or monthly repayment

schedules and a 6-month to 2 year term. Microfinance institutions typically

charge a higher rate of interest to their clients than traditional commercial

banks as the administrative costs of servicing smaller loans is far higher in

percentage terms than the cost of servicing larger loans. Additionally, Micro

Finance Institutions provide doorstep services to their customers, a strategy

that has a high cost associated with it, especially in rural areas where

population densities tend to be low. Because of this model, Micro Finance

Institutions generally face an operating expense ratio (OER) between 6% and

15%, depending on the scale and efficiency level of the particular MFI as well

its area of operations. Additionally, today, Micro Finance Institutions face

borrowing costs in the range of 12% to 16% per annum, depending on the size

and track-record of the individual MFI.


Metric Amount (in words)

Interest rate charged Typically 25-35% p.a.

Interest on debt12-16%; lower for larger Micro Finance

Institutions

Operating expense ratio 6-15% depending on level of efficiency

ROA Typically 3-5%

Debt/Equity Typically 5-8x

ROE 20-30%


33/112


This model allows well-run Micro Finance Institutions to achieve a ROA

of about 3% to 5% and a ROE of as much as 20% to 30%. These high ROA and

ROE numbers are contingent upon low cost financing from commercial banks

and the ability to maintain high portfolio growth along with high portfolio

quality. The portfolio quality for Micro Finance Institutions is typically superior

to commercial banks with total Non- performing Assets 180 days past due of

0.2% to 3% as opposed to 3% to 10% for commercial banks. Micro Finance

Institutions typically enjoy extremely low delinquency rates despite the

nonexistence of security. This portfolio quality is driven by the discipline

embedded in the JLG model through the self-selection of the group members

as well as the mutual support informally embedded in the groups in relation to

members loans.

The 3% to 5% ROA range is a product of both the maturity level of Micro

Finance Institutions and the basic business model to which they subscribe. No

MFI typically begins by achieving a 3% ROA, but it can be achieved and

becomes sustainable as the MFI refines its business model and scales enoughto become profitable. Within this range, however, an MFIs ROA will be

determined largely by its particular business model. For example, within Lok

Capitals portfolio, Spandana has consistently had an ROA above 5% since

Loks investment in August 2007. By and large, Spandana faces the same cost

of debt as the rest of the industry, however, its single-product business model

hinges on maintaining a consistently low OER, which has also been below 6%

since the time of Loks investment. This low OER allows Spandana to charge

one of the lowest interest rates on its loan products in the industry and thus

successfully serve its social mission. By contrast, Bhartiya Samruddhi



34/112


(BASIX) is a mature MFI with an ROA between 2% and 4% and a different

approach to the microfinance business model.

As a mature MFI, BASIX has begun exploring alternative products and

services, financial and non-financial to form deeper linkages with its existing

clients and maintain its competitiveness. While BASIX may make slight

improvements in its OER in the future, that will not be its key focus.

Nevertheless, as it continues to strengthen its client base, develop its product

base and expand at a sustainable rate, BASIX will continue to comfortably

produce an attractive ROA. Ujjivan presents a blend between the models of

Spandana and BASIX. Ujjivan, which is a less mature MFI partner, has only

recently achieved an ROA above 3%. Ujjivans business model currently

operates on an assumption of an OER in the mid-teens as it is still in the

process of ramping up its operations at an extremely high rate. Ujjivan seeks

to become a larger commercial player in the sector, but it is simultaneously

dedicated to expanding into untested geographical territories and targeting

clients who continue to be excluded from the microfinance sector.

The groundwork required in this approach makes for inherently high

operating costs. As Ujjivan matures and its business model gains more

cogency, its OER will certainly continue to decline, ensuring a healthy and

sustainable ROA going forward. These three examples are reflective of trends in

the sector overall. Nascent Micro Finance Institutions make gains in ROA as

they scale their businesses and then remain within the 3% to 5% range as they

streamline their business models to reflect their longer-term goals.

3.3 Social Mission financial Inclusion



35/112


While microfinance presents a viable commercial opportunity, the sector cannot

ignore its underlying mission to foster financial inclusion and the missions

importance to ensuring its long-term sustainability. Being constantly vigilant of

its social impact and implementing a definitive program to foster inclusion, will

serve to deepen the microfinance sectors commitment to the social mission

that it was created to execute and prevent it from becoming disengaged from its

social agenda even as it gains scale. In other words, even as they become

commercially successful, Micro Finance Institutions need to keep the interests

of their current and potential customers at the forefront of their strategic

decision-making process. Awareness of the customers interests feeds into the

sectors strategy from two angles: capacity and need.

Micro Finance Institutions have a responsibility to be truly discerning of

potential customers capacities to avoid over-indebtedness and credit-

dependence which ultimately keeps them trapped in poverty. From a need

angle, microfinance institutions cannot hope to ensure successful long-term

futures by offering a single product to their consumers, who wish to utilizetheir increased financial capacities to acquire services and products such as

education and healthcare that improve their quality of life. Moreover, Micro

Finance Institutions need to diversify their customer base through exploring

untapped geographies and still excluded segments of the low-income

population. This strategy will ensure that the social mission of Micro Finance

Institutions remains intact and that the business continues to be successful

over the long run, achieving the ultimate social-commercial balance and

strengthening the double bottom line advantage.

3.4 Market Trends



36/112


As the Indian microfinance sector matures, Lok Capital expects the year-on-

year growth rate to decline to still high, but more sustainable levels. Over the

next four years, Lok Capital projects the number of borrowers to grow at 34%,

which is 60% less than the historical 5-year CAGR of 86% and the portfolio

outstanding to grow at 40%, which is 58% less than the historical 5-year CAGR

of 96%. Even with these cautious assumptions, Lok Capital expects MFI

borrowers to increase from 22.6 million to 64 million and portfolio outstanding

to increase from $2 billion to $8 billion by 2012.

With maturity, Micro Finance Institutions will have to begin reassessing

and re-engineering their growth strategies in a couple of years. They will have

to take into account market opportunities and risks and adjust their

geographical exposure, client base and product offering to remain competitive.

Hints of market conditions that Micro Finance Institutions will have to navigate

in the coming years are present even today, and Micro Finance Institutions are

beginning to recognize these factors as they continue to grow. Below we explore

the changing market dynamics in terms geographical spread of microfinance,

client profile and product offerings and evaluate how Micro Finance

Institutions might respond.



37/112


3.5 Geographical Spread

Despite the rapid expansion of microfinance, large areas of India

continue to be underserved. Lok Capital estimates that the penetration

potential of the existing microfinance model is between approximately 43

million and 52 million households, out of which 22.6 million are existing

customers. This implies an unaddressed demand of 20million to 29 million

customers. Currently, as many as 54% of all microfinance clients are

concentrated in the Southern States: Andhra Pradesh, Karnataka, Kerala and

Tamil Nadu.

Alternatively, there is an extremely limited microfinance presence in

the North and North-east. Micro Finance Institutions are beginning to realize,

however, that the South is becoming overly saturated and there is a commercial

need to expand to newer geographies to ensure continued growth and maintain



38/112


the quality of their portfolio. It has become imperative that Micro Finance

Institutions diversify their operational base and limit overexposure to heavily

serviced areas and clients. The Karnataka episode (detailed below) has

demonstrated the urgent need to re-engineer expansion strategies to avoid over-

lending to a cluster of clients and hedge against regional disturbances,

economic, political and social.

3.6 Client Profile

We have begun to see greater microfinance activity in states such as

Maharashtra and Madhya Pradesh, but Micro Finance Institutions are

approaching the North and North-east with more caution and hesitancy

because these areas present a very different type of client base compared to

South or Central India. Nonetheless, the trend toward expanding in uncharted

territories will continue, albeit slowly. In addition, Micro Finance Institutions

are trying to start tapping different portions of the low income segment. Thus

far, a very narrow band of the low-income population segment has been served

through microfinance.

There is an ultra-poor segment as well as a wealthier one which have

drastically different needs and capacities from the segment currently being

served. Small efforts are underway to explore these segments needs and

capacities and evaluate what kind of products and services would allow them

to be brought under the financial inclusion umbrella. For example, with help

from Lok Foundation, Ujjivan is currently participating in a pilot program for

the urban ultra-poor which seeks to equip them with knowledge and skills that

will allow them to eventually avail microfinance services.



39/112


Moreover, the government has also of late turned its focus toward

financial inclusion. This means that policy and regulatory attention on

microfinance has increased with the government constituting two high-level

committees to provide suggestions on how to improve the financial inclusion

scenario in India. This new trend will provide impetus to devise strategies for

more inclusive growth that makes commercial as well as social sense.

3.7 Product Offering

Thus far, microfinance institutions have largely limited their

product and service offering even within the confines of financial inclusion. In

fact, their product innovation has been limited to credit which is intended to

serve a variety of needs as shown by the box below. The limited product

innovation is understandable given the sectors primary focus has been on

refining its business model and gaining scale to become financially sustainable.

Despite following a single-product model, the sector has experienced

remarkable growth. This growth can only be expected to continue as product

innovation and diversified service offerings attract and retain greater number of

customers with a variety of needs.



40/112


The very same clients that the sector currently serves have a plethora of

alternate needs for basic products and services, financial and non-financial

which can affect sustainable, long-term achievements in their quality of life.

Fortunately, recognizing this pent-up demand, mature Micro Finance

Institutions are beginning to take concrete steps toward expanding their

product basket, at least within the context of financial services. Along with

credit, Micro Finance Institutions are heavily exploring the possibility of

providing savings/deposit services, micro-insurance and remittance services.

Savings

Access to a savings mechanism like that which is available through

commercial banks, is usually held by the microfinance industry to be the most

urgent need to enhance the economic security of the poor. Due to RBI


Product Purpose

Existing

Product

New/Niche

Product

Micro Enterprise/Small Business Loan

Working Capital

Agriculture Loan

Crop/Farm Related

Livestock Loan

Dairy/Poultry

General

Consumption

Educational Loan

Vocational

Housing Loan

New Home


41/112


regulations, Non-Banking Microfinance Company (NBFC) Micro Finance

Institutions cannot currently accept interest-bearing deposits, unless they

provide the service through a Section 25 Business Correspondent conduit.

This structure prohibits the conduit from charging any fees to execute this

function and limits its reach within a limited radius of the bank branch. Micro

Finance Institutions are lobbying the RBI to relax these regulations to allow

NBFCs to operate as business correspondents, charge an extra fee for the

deposit-taking service and delimit the geographical reach of their operations.

These changes would not only make deposits a viable commercial product, but

also allow Micro Finance Institutions to offer it to a broader set of clients.

3.8 Insurance

While credit can serve to enhance a households income, insurance

can serve to cushion the negative economic impact in the event of an

emergency. Without insurance, a single incident can often impoverish a

household, even with access to micro-credit, especially if the emergency affects

the main earning members. A number of Micro Finance Institutions already

offer micro-insurance products to their clients. The most basic products insure

against health and accidental death. Companies such as Satin and BASIX

usually tie the insurance products to their credit products, which makes the

availability of credit contingent on the client availing insurance. The rationale

behind packaging the loan and insurance together is that often clients do not

understand the importance or benefit of insurance until they face an

emergency. From a commercial viewpoint, the MFI is in effect insuring its loan

against a crisis in the clients household, since insurance hedges against total

financial collapse and thus ensures repayment of the loan, albeit in a delayed

fashion. Similar to customers, BASIX also links livestock loans to livestock



42/112


insurance for a similar reason it cushions the financial blow and increases

the likelihood of a successful loan recovery. We can expect the number of

insurance products available to increase as Micro Finance Institutions expand

beyond their core credit product and clients become more aware of the benefits

of insurance.

3.9 Remittance

Domestic labor migration has a long history in India and is on the

rise given disparities in growth across states migrants need a fast, low-cost,

convenient, safe and widely accessible money transfer service. In India,

remittance services can be enabled by the provision of savings and thus need

to be provided in tie- ups with banks and post offices. In some cases, Micro

Finance Institutions provide remittance services by establishing their presence

in a migrant destination to channel remittances back to the community in the

migrants area of origin or by establishing a tie-up with another MFI, bank or

money transfer company in the area of origin. Going forward, the role of

technology will become more important in facilitating the development of

alternative channels and payment mechanisms.

3.10 Non-Financial Products

Within product offerings, Micro Finance Institutions are considering

expanding their activities beyond the realm of financial services since this can

provide synergies linked to future expansion. Microfinance clients have myriads

of unmet needs such as healthcare and education as well as livelihood

requirements which can enhance their income, employment potential or quality

of life. Given Micro Finance Institutions existing relationships with this



43/112


population segment, they would be an ideal channel to provide these services.

While Micro Finance Institutions may not want to delve into product lines that

are fundamentally different from their core business, they could easily act as

conduits to allow other agents to deliver these services to their customers. The

microfinance industry as a whole is now experimenting with a wide variety of

potential models that could be used to deliver non-financial services.

For example, BASIX offers a host of alternative services to its clients.

Beyond the basket of credit and other financial products and services, BASIX

also provides low income customers with livelihood services, including

agricultural and business development consulting services, to help

microfinance clients use their loans more effectively. BASIX offers these

alternative services to its clients through different entities housed under one

umbrella. These groups have tremendous synergy and contribute to each

others growth and prosperity. The credit business enables customer

acquisition, while the insurance business mitigates risk, and agricultural and

business development service enables customer retention. The consulting andIT business enhances BASIXs revenues, while the social businesses enable

research and development which contribute to BASIXs strategy development.

In addition to livelihood services, several Micro Finance Institutions are

examining the feasibility of providing critical basic services to deliver low cost

healthcare, education and vocational training. For example, Spandana is

currently developing a comprehensive low cost healthcare delivery model

focused on the healthcare needs of women and children. BASIX has launched a

vocational training academy to impart education in rural development and

management to potential job seekers from low income communities.



44/112


These participants would be deployed in the rural/semi urban areas

with BASIX or other organizations offering financial services to the poor. In

addition to being important avenues for productive utilization of credit by MFI

clients, these types of services have a strong potential to reinforce long-term

client relationships. Most importantly, the evolving delivery model for low cost

education and healthcare has similar operational elements as the highly

successful microfinance model including efficient distribution, high-

throughput and para-skilling of low cost resources to address the last mile

inclusion challenge

3.11 Potential End Game Scenario

Since Micro Finance Institutions asset growth rates may be more

moderate over the medium term, they will need to make strategic choices based

on their capabilities and the competitive environment. National players will

focus on achieving pan-India scale and efficiently delivering fewer closely-

linked products while regionally focused Micro Finance Institutions will try to

leverage their deeper ties with clients (due to proximity and awareness of local

dynamics) and provide additional services.

3.12 Investment Climate

Today, microfinance is gaining prominence as a viable asset

class globally, particularly in India. Micro Finance Institutions in India have

continued to attract large amounts of capital despite the global economic

recession. Currently, it is reported that over 100 microfinance investment

vehicles (MIVs) exist globally, and India is a focus for many of them due to its

large market size, growth capacity, profitable business models and potential



45/112


development impact. Moreover, mainstream investors are beginning to

participate in this sector, picking up larger stakes than the social investors that

have been dominant so far. The entrance of mainstream investors is indicative

of an industry that is maturing, but is still expected to grow at a high rate.

Valuations in the microfinance sector reflect this expectation and

surpass that of traditional institutions in the financial services space.

Moreover, Indian Micro Finance Institutions trade at significant premier to

Micro Finance Institutions in other parts of the world. Micro Finance

Institutions across the world face an equity valuation of 1.5x to 3.0x book

value, whereas Indian Micro Finance Institutions face a valuation that is 3.0x

to 4.0x book value. This premium is driven partly by the generous amounts of

debt available to the industry to expand which in turn enables Micro Finance

Institutions to achieve returns on equity of approximately 20% to 30%.16 These

premium levels are also identical to the premier to book value at which private

sector banks and non-banks have traded in the Indian capital markets which

have averaged over 3.5x to 4.0x book value throughout the last seven to ten

years. In the short run, as mainstream investors gain interest in the Indian

microfinance industry and infuse larger amounts of capital at higher prices,

equity will continue to trade at a premium.

A point to note here is that even though the microfinance industry is

reaching maturity, the large amounts of untapped geographical territory and

client base combined with the Micro Finance Institutions wide network create

potential for enormous sustainable growth in the future. As discussed earlier,

Micro Finance Institutions and other service providers are beginning to realize

the significant value of the network that has been created by Micro Finance



46/112


Institutions and efforts are underway to utilize them to deliver both, financial

and non- financial products and services. These factors will continue to impact

the supply of equity for Indian microfinance and hence the equity valuations.

Furthermore, since this untapped demand is unlikely to be satisfied in the

short or medium term, while valuations will be tempered by cautious investors,

premier driven by fundamental growth expectations can be expected to prevail

through the short and medium term as Micro Finance Institutions re-engineer

their strategies to take advantage of the unsatisfied microloan demand.

3.13 Exits

For early stage investors like Lok, the most likely source of exit

remains secondary or trade sales. Given the multiple rounds of capital raisings

that fast growing MFIs need to complete and the increasing investor interest

(including from large commercial investors) in taking direct exposure to Indian

microfinance institutions, there is significant opportunity for early-stage,

nimble investors to sell their stake in subsequent rounds. For example, as part

of Spandanas current capital raise of approximately $40 million from

mainstream investors, Lok is doing a partial exit of its shareholding in the

company, realizing a cash on cash multiple of 8x on the shares sold. Early

stage investor Kalpathi Suresh recently sold a 10% stake in Equities to Sequoia

Capital, generating over 12x returns, demonstrating that it is possible for

minority investors to successfully exit their microfinance investments.



47/112


In terms of potential M&A exit scenarios, the most likely scenario is

the entry of banks as acquirers in the medium term with the RBIs and the

governments emphasis on using banks to deliver more effective financial

inclusion they could leverage MFIs as the last-mile distribution platform for

the existing banking system. Banks could potentially find it easier to complete

acquisitions compared to large MFIs as they are less promoter driven and have

better institutional capacity to integrate acquisitions. Acquisitions of regional

MFIs by large national MFIs is also possible given certain conditions the

regional MFI would need to have strong penetration in its local market, a

similar basic operating model as the acquiring MFI and a certain minimum

portfolio size of approximately $50 million to $75 million. The MFI sector could

also see a merger of equals between two mid to large sized MFIs as the industry

matures and consolidates over the medium term.

Some large MFIs including two to three in Lok Capitals portfolio could

consider a potential listing in one to two years, but IPOs will be a challenge for

the sector overall given limited market experience in listing socially-focused

firms. Criteria for a successful IPO will include size; the capacity to absorb

large amounts of capital and generate post-issue liquidity of the listed shares;

operating experience of the management team; track-record of value creation;

and institutional capacity to deal with the listing process, compliance

requirements and public scrutiny. In this regard, the experience of SKS

Microfinance in executing its proposed IPO in 2010 will be a useful learning

experience for the microfinance sector to determine

1. INTRODUCTION AND METHODOLOGY 1.1Introduction The poor, like the rest of society, need financial...

Documents

Transcript of 1. INTRODUCTION AND METHODOLOGY 1.1Introduction The poor, like the rest of society, need financial...